Cautiously optimistic on global growth

Key points

We believe this year’s emerging-markets’ sell-off will ultimately blow over without lasting damage to developed economies and markets.

The longer emerging-market troubles persist, the more likely something nastier crops up such as large default-related losses by Western banks with emerging market debt exposure.

While market sentiment has been dented this year, we believe the global economy remains in good shape.

When a semblance of calm returns to emerging markets, promising investment opportunities could emerge.

Equity markets around the world have been spooked this year by troubles in emerging markets. Unlike the sell-off in the area seen in the middle of last year, we believe monetary tightening in the US has little to do with the turbulence this time.

The indiscriminate selling of emerging market assets has not been confined to equities with bonds and currencies also under pressure. The Argentinean peso, South African rand and Turkish lira were particularly badly affected. The Turkish central bank nearly doubled interest rates in January to stem capital outflows, with limited success.

Emerging markets under pressure

Global equities have been struggling since the start of the year with emerging markets hit hardest. Equities are now in “correction” territory, with most developed markets down by six to eight per cent from last year’s peaks.

The falls in developed equity markets follow large gains last year. However, we believe there is a genuine cause for concern in some emerging economies, especially Brazil, India, Indonesia, South Africa and Turkey. These countries run large government and current-account deficits, and so are more dependent on foreign finance than most.

Sell-off should blow over, eventually

We believe this year’s emerging-market sell-off will ultimately blow over without lasting damage to developed economies and markets. However, the longer this episode persists, the more likely something nastier crops up.

The biggest danger is that one or more emerging nations suffers a sudden halt of capital inflows and/or capital flight. This could require the current-account deficit to be closed rapidly, prompting a recession. In those circumstances, emerging debt markets look very vulnerable to us. Indeed, in the most extreme circumstances a sell-off in hard currency corporate bonds could cause a financial crisis if the emerging-market carry trade were to unwind too quickly. In turn, many Western financial institutions could suffer large default-related losses on their emerging-market corporate bond investments.

We stress again that we regard the above scenario as being very unlikely. All our risk-on/risk-off indicators remain in risk-on territory, though a couple of them have moved sharply of late. We remain vigilant, but prefer to insure against this low-probability outcome by investing in US dollars.

Cautious optimism for global growth

While market sentiment has been dented this year after the euphoria of last, we believe the global economy remains in relatively good shape.

An interest rate rise in the US and UK is on the radar, but we believe it is unlikely before 2015. Meanwhile, the outlook for growth in both countries, and Japan, is promising. Even in the euro zone, prospects for growth look a little brighter, although the pace is modest and the distribution across member countries uneven.

Our multi-asset portfolios have been underweight emerging-market assets and overweight developed ones for some time. This is unlikely to change in the short term. However, the outlook for some emerging economies, especially in South-East Asia, is encouraging. When a semblance of calm returns to emerging markets, promising investment opportunities could emerge for discriminating investors.

Shamik is a former Director of Fathom Consulting, a research company which he developed from a start-up to a thriving business. He has also held positions at HM Treasury, Oxford Economic Forecasting and the Bank of England, where he was a senior manager in the UK forecasting and monetary policy divisions. He holds a BA (Hons) in PPE from Oxford University and an MSc (Econ) in economics from University of London (QMC).